Distribution Strategy, Capability Investment, and Government Regulation

This paper investigates how a manufacturer’s internal sourcing capability and government regulation influence the supplier’s distribution strategy and the manufacturer’s sourcing and capability investment decisions. We consider a supply chain consisting of a supplier that produces a critical component, an independent manufacturer that also has the capability to produce the component in-house, and a dependent manufacturer without such capability. We first consider a scenario in which the supplier chooses its distribution strategy—either offering its component to both manufacturers or establishing an exclusive selling agreement with a single manufacturer. We explore how the supplier’s optimal distribution strategy (dual or exclusive selling) depends on the terms and process of the contract and on the independent manufacturer’s ability to produce a high-quality component in-house. We also show that, in equilibrium, the independent manufacturer may invest in a high capability level (leading to a high-quality component) as a strategic deterrent against the supplier’s decision to engage in an exclusive selling agreement with the dependent manufacturer. We further consider a setting with mandatory exclusion, imposed by government regulation, that affects free trade among parties. We show that mandatory exclusion can exacerbate or mitigate the independent manufacturer’s incentive to invest in internal sourcing capability, relative to a setting in which the supplier determines its distribution strategy in the absence of such government regulations. Moreover, we show that mandatory exclusion always hurts the supplier, but it can benefit or hurt the manufacturers as well as the consumers, depending on the independent manufacturer’s investment cost and the conditions leading to an exclusionary contract under free trade.